Misallocation or Risk-Adjusted Capital Allocation?

Standard, frictionless neoclassical theory of investment predicts that the expected corporate marginal product of capital (MPK) depends on firms' exposure to systematic risk and the price of that risk. This implies that the cross-sectional dispersion in MPK i) depends on cross-sectional variation in risk exposures and ii) fluctuates with the price of risk, and thus is countercyclical. We empirically evaluate these predictions and document strong support for them. In particular, a long-short portfolio of high minus low MPK stocks earns significant and countercyclical excess returns forecastable by standard return predictors. A calibrated investment model suggests that ex ante variation in risk exposure can rationalize permanent dispersion in MPK. These findings suggests that a substantial fraction of dispersion in MPK, often dubbed misallocation, is effectively risk adjusted capital allocation.